Visionaries and Pragmatism in Financial Regulation

In a world of “alternative facts” and political rhetoric crafted to mislead, it is easy to forget that idealized visions can at times illuminate more than they obfuscate. In a book review recently published in Harvard Law Review and available here, I attempt to separate fact from fiction in the debate about how best to regulate short-term debt. Although coming down in favor of pragmatism in financial policymaking, the review recognizes the ways that imaginative alternatives can reveal often-obscured choices and help lay the foundation for a better path forward.

The thought-provoking book that motivates the review is The Money Problem: Rethinking Financial Regulation by Morgan Ricks. Ricks’ argument is bold and enticing: Panics are the core problem for financial regulation. Panics arise when short-term creditors, like bank depositors, run en masse. By imposing meaningful restrictions on the issuance of short-term debt and having the government insure all such debt, we can build a stable financial system. Moreover, by bifurcating the creation of short-term debt from other types of financial activity, we can still harness the benefits of innovation and creativity. This is possible because once the government controls the market for short-term debt, it can play a far more modest role overseeing and regulating the rest of the financial system.

This is is a beautiful vision. It is also serves as a reminder that the structure of the financial system is not a byproduct of chance or market forces alone. Law is also central. Changing the legal ground rules can fundamentally alter the structure of the financial system.

Ricks is not alone in helping to illuminate these dynamics. Other prominent academics, including Irving Fisher, Milton Friedman, and, more recently, Adam Levitin, have promoted reforms that rely on the same basic premise.[1] Each of these proposals focuses attention on the ways that short-term debt contributes to fragility and raises important questions regarding the structure of our financial system.

Just as importantly, a host of legal scholars, including Katharina Pistor, Robert Hockett, Saule Omarova, Dan Awrey, Anna Gelpern, and Erik Gerding, are drawing much needed attention to the fundamental role of law in enabling and shaping modern finance.[2] These dynamics also motivate my recent work on changing investor preferences as a mechanism through which the law can inadvertently encourage financial innovation and exacerbate fragility.[3] This body of work is more than the sum of its parts. In building upon, challenging, and complementing work by economic historians, political scientists, and sociologists (who have long recognized the role of politics and the law in shaping finance), the recent legal scholarship reveals the choices we are making without even realizing that we are making them and the values that are compromised in the process.

Ricks by no means situates himself or his proposal in this larger movement. His aim instead is to provide a singular, innovative vision for how to construct a banking system that is immune to panics. As the review addresses in some detail, examining his vision through an historically informed lens and contrasting his imagined landscape with the world that we inhabit casts doubt on the viability or attractiveness of his proposed reforms. But it also brings into relief the ways his vision can illuminate the challenges we are facing and how best to address them.

Make no mistake, Ricks’ policy proposals are radical. He would do away with money market mutual funds, commercial paper, repo, and virtually any other debt-like obligation with a maturity of less than a year. In his world, there would be one type of bank account. Everyone, from an individual with meager savings to firms like Apple and institutional investors like Blackstone, would have such an account. That account would offer returns of zero, irrespective of whether the country is in the midst of deflation or massive inflation. And the government would ensure 100 percent of the balances in 100 percent of these accounts. The claim, recall, is that eliminating private short-term debt will end financial panics. The ability to panic proof the financial system would justify the significant costs of implementing and maintaining his regime.

Putting costs to the side, the core question is the impact of Ricks’ proposed reforms on financial stability and resilience. To work, the system must shut down other forms of banking and private money creation. Although Ricks carefully constructs his prohibition to preclude familiar forms of shadow banking, history suggests it is the activity not yet recognized as “banking” that often proves to be the most dangerous. As Neel Kashkari explained based on his front-line role during the last crisis: “[W]e won’t see the next crisis coming, and it won’t look like what we might be expecting.”[4] Looking further back, recent work by Hugh Rockoff reveals that 11 of the 12 significant financial crises in the history of the United States emanated, at least in part, from their respective eras’ version of the shadow banking system.[5]

This suggests that shadow banks and private money creation will again emerge, whether driven by insufficient authorized money or the high cost of holding such money. A regulatory regime that does not anticipate such dynamism can itself inhibit the capacity of regulators to identify and respond to new threats. Taking this dynamism seriously favors a regulatory regime that is responsive rather than rigid, and regulators who bring more humility than hubris to the challenge of identifying systemic risk.

One way to reconcile these challenges with Ricks’ valuable insights regarding the importance of short-term debt and the unique efficacy of government guarantees in stopping panics is to devise a system that balances ex ante efforts to avoid excessive creation of private short-term claims with an ex post regime to more effectively contain panics when they inevitably arise. A more modest approach ex ante would reduce the ongoing costs, such as foregone credit creation and the loss of any market discipline. At the same time, instituting a guarantor of last resort would allow the government to respond swiftly to minimize the systemic damage once widespread panic sets in, and it could target the source of that fragility irrespective of where it arises in the financial system.

There are no easy answers when confronting the question of how best to construct a financial system capable of supporting a growing economy and yet resilient during periods of systemic distress. In drawing attention to the possibility of a regime radically different than the one that we have, Ricks highlights the importance of law in constructing the financial system, including its sites of fragility. These insights make the book an important read for anyone interested in how we can address the weaknesses baked into our current regime.